2 Competitive advantages that drive inventory returns | Smart Change: Personal Finance

There are many traits of great companies, but one thing they all have in common and that is some kind of competitive advantage. The ability to recognize if a company has an advantage over its competition is integral to successful investing, which is why it is so important to understand two of the greatest competitive advantages in business: network effects and counterpositioning.

Let’s separate what they are and how to determine which companies show these advantages.

Network effects are a phenomenon in which the value of the network increases exponentially with each user who joins. According to a study by NFX.com, nearly 70% of the total value generated by Silicon Valley is attributed to network effects.

A simple example of the network effect is the Internet itself. When the internet was first connected, the value was very limited. In fact, the first version of the Internet was created by the US government for military use only, so the value was limited to internal users within the US Department of Defense.

But once the internet became publicly available, its value rose rapidly as more users started interacting on the network. The bottom line is that users drive value creation. Without them, the net would be dead in the water. And as more users joined, the value increased exponentially.

Today, network effects are seen in all technology companies, from ID pads to me Airbnb. But not all networks are created equal. The usefulness and experience of the network affect the strength of the competitive advantage.

etsy (NASDAQ: ETSY) It has a strong network effect because it is a unique market. With more vendors and users joining the platform, the value on both sides of the network has increased exponentially. This is largely due to the unique experience that improves with each additional node added.

An example of a network effect with limited advantages is Uber (NYSE: UBER). When Uber launched its ride-hailing service, it actually had a strong impact on the network. As more drivers join the network, the value proposition to users has increased exponentially, as they can direct rides to more places. But the benefit of the service is to get from point A to point B. That’s it.

so when Lift (NASDAQ: LYFT) They launched a competition network, and both drivers and passengers were happy to go to whichever platform offered them the best value. This eventually led to a race to the bottom in terms of pricing for these two companies. Despite their presence, the network effects of Uber and Lyft are weak at best.

Counter-positions occur when an industry newcomer adopts a superior business model and incumbents do not imitate the change for fear of harming their business.

This is a powerful advantage because the turbulent factor puts the market leaders in a difficult position. As you might expect, it is very difficult to completely change your business model, especially if you are a multibillion dollar company. So the incumbent is forced to take the incredible risk of trying to steer its entire business model or continuing to operate on its current model, knowing that it is inferior to the newcomer.

This example is fully illustrated in Blockbuster and Netflix (NASDAQ: NFLX) long story. Netflix, the newcomer, has adopted a unique and ultimately superior business model: subscription entertainment, first by mail and then by streaming.

By contrast, Blockbuster’s business model was based on opening as many stores as possible across the country. So when Netflix came on the scene, Blockbuster had to make a choice: either steer the business away from personal rentals and switch to a subscription model, or continue the course. We all know what they decided and the end result.

From the incumbent’s point of view, there is no good choice. But often these companies choose to stay the course because they feel less risky, or they doubt the viability of the new model.

One of the current examples of this phenomenon unfolds between Tesla (NASDAQ: TSLA) And OEM companies for existing cars. Tesla’s business model does not include advertising or the use of agents for distribution, allowing it to enjoy higher margins. At the same time, an incumbent like Ford Motor (NYSE: F) And the general motors (NYSE: GM) Relying heavily on advertisements to get the mind’s attention is beholden to the agent guilds, which Tesla avoided.

Only time will tell if the incumbents make the right decision by continuing the course.

As an investor, being able to perceive the existence and strength of competitive advantages gives you an enormous advantage. It requires you to be very familiar with both the industry and the business models of the players within it.

While this requires a tremendous amount of work, it is the key ingredient in building conviction, and therefore superior long-term performance.

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Randy Zuckerberg, former director of market development and spokesperson for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool’s board of directors. Mark Blank holds positions at Airbnb, Inc. and Tesla. Motley Fool has positions at Airbnb, Inc. and Etsy and Meta Platforms, Inc. and Netflix and Tesla and recommends it. Motley Fool recommends Uber Technologies. Motley Fool has a disclosure policy.